Reverse mortgages are a way for elderly people to draw an income (either in installments or a lump sum) against the equity that they've built up in their homes. For many older people in need of funds to live on, it is nothing short of a blessing, but there are some pitfalls to the process that everyone should consider. Find out what you need to know before taking the plunge. (For further reading on reverse mortgages, see The Reverse Mortgage: A Retirement Tool.)

High Costs

Although an individual is technically tapping the equity on his or her own house, the bank charges a fee to initiate the transaction. In fact, according to ReverseMortgage.Org, as part of a reverse mortgage, homeowners may be required to pay an origination fee of $2,000 or 2% of the loan amount, whichever is higher. Some homeowners choose to fold this fee into the loan and pay it back over time with interest.

In addition, there are other fees that homeowners may be responsible for, such as an appraisal fee, which can range in the hundreds of dollars, a recording and credit report fee, which tends to be about $200, and a pest inspection and a flood certification fee, which are about $150 (for both). Finally, homeowners may also be asked to get mortgage insurance, and may be charged a flat monthly account "service fee", which can range from $30 to $35 a month. In short, the costs associated with a reverse mortgage can initially nibble away at the income you'll receive.

Given the substantial upfront costs associated with the process, homeowners in need of liquidity who are considering selling their homes within the next several years would probably be better off applying for a more traditional line of credit, a home-equity loan or a personal loan. (To learn more about home equity loans, see Home-Equity Loans: The Costs and Home-Equity Loans: What You Need to Know

Your Kids Might Not Inherit the Family Home

Parents may like to pass the family home onto the next generation. However, when a reverse mortgage is taken out, even though the lending institution does not take title to the home, the mortgagee has an obligation to pay back the loan according to the terms of the agreement. In many cases, that repayment is made by selling the home and then turning over the proceeds (or a portion of them) to the bank.

As a possible workaround to avoid selling the family home, some families will take out an insurance policy on the homeowner and make an adult child or the lending institution the beneficiary. Using this strategy, the bank may be repaid without having to sell the property upon the homeowner's death. Consider consulting with an insurance agent to determine the best way to ensure that proceeds from such a policy are sufficient enough to satisfy the outstanding loan.

Reverse Mortgages May Impact Medicaid Benefits

Lending institutions are quick to say that obtaining a reverse mortgage will not affect one's Medicaid payments, but for this to happen, they must be structured very carefully. A lump sum payment, for example, will count as an asset that you would need to spend down before you would be eligible for Medicaid payments.

However, according to LongTermCare.gov, from the U.S. Department of Health and Human Services, "As long as you spend the payments you receive in the month that you receive them, the money is not taxable and does not count towards income or affect Social Security or Medicare benefits." Such payments also do "not count as income for Medicaid eligibility."

LongTermCare.gov also states that if the total liquid resources are more than $2,000 for an individual or $3,000 for a couple, this could make the person ineligible for Medicaid. However, if you receive monthly payments that you spend on your ongoing expenses, and don't accumulate savings, you may be all right. For details on choosing how to receive proceeds of a reverse mortgage, see How to Choose a Reverse Mortgage Payment Plan.

Individuals currently receiving – or who anticipate receiving – Medicaid should consult an accountant and a financial advisor in order to make certain that they are aware of all of the potential ramifications of taking out a reverse mortgage. (To learn more about Medicaid and long-term care, see Medicaid vs. Long-term Care Insurance, Failing Health Could Drain Your Retirement Savings and Long-Term Care: More Than Just a Nursing Home)

Other Pitfalls

While the lending institution may neither go after your heirs for money, nor be entitled to take more than the appraised value of your home, there are several items usually located in the fine print of these contracts that can be disturbing.

Being forced to sell. For example, some reverse mortgages have clauses that state that the loan must be repaid if the last surviving borrower permanently moves out of the home. This raises the concern that you could (hypothetically) be in the hospital receiving treatment for a medical condition and be released to find that your home is in foreclosure. In fact, you'd have to have lived somewhere else (such as a nursing home or assisted living facility) for more than 12 months – a situation that counts as a "permanent move," and can trigger the requirement to sell your home.

Being responsible for other payments. Furthermore, because homeowners remain responsible for all taxes, insurance and upkeep on the home, failure to pay taxes or maintain adequate insurance could cause the loan to be called.

Getting less than expected. Keep in mind that the property is also subject to an appraisal. So, while you might have put a large amount of money into your home over the years, there is the chance that it's worth less than you paid. This means that the proceeds that you receive as part of the reverse mortgage process may be less than what you might have anticipated.

The Bottom Line

Reverse mortgages are a great way for people to tap the equity in their homes, either in installments or in a lump sum. However, be aware of the potential downsides to entering into such an agreement. (To find out more, check out Is A Reverse Mortgage Right For You?)

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